Question

“The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk”. Critically assess the former statement. Do you think multi-factor models might perform better? Why or why not?

Answer 1

The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. This statement tells that the CAPM model descibes the relationship between the systematic risk and expected returnfor assets particularly for stocks.This model is widely used thoroughout finance for pricing risky securities and generating expected return for assets given the risk of those assets and cost of capital.Investos expect to be compensated for risk and the time value of money.The risk free rate in the CAPM formula accounts for the time value of money.The other components of the CAPM formula accounts for the investor taking on additional risk.

Multifactor models describe the return on an asset in terms of the risk associated with the asset with respect to a set of factors. Such models generally include systematic factors,which explains the average returns of a large number of risky assets.One such model is the Arbitrary Pricing Model(APT). I don't think the multifactor models can perform better because unlike the CAPM model these multifactor models provides with less strong assumptions.